Microsoft Corp. is backing up its talk of investing in Web services with cash, months after chairman Bill Gates called the company to arms over an Internet "sea change" in which software and services become delivered over the Web.
Next year the company will invest $2 billion more than expected in a variety of technologies, and the clearest goal is to transform its way of doing business on the Web, analysts and investors said.
Wall Street was shocked by additional spending plans announced on Thursday, sending shares down more than 11 percent on Friday. Microsoft arguably is coming from behind, having ceded the early advantage in online advertising.
But history smiles in Microsoft's favor.
"If you look at Microsoft historically, it's usually had a second-mover advantage," said Todd Lowenstein, a co-portfolio manager for HighMark Capital Management's Value Momentum Fund who holds shares of Microsoft.
"Microsoft hasn't really been the one to innovate, but to copy and then leapfrog the first mover and that's been the company's modus operandi," he said.
"Microsoft must feel threatened and it wants to draw a line in the sand," he added. "The jury's still out on whether that makes good economic sense."
Microsoft's Windows operating system was not the first graphical user interface, but Windows grew to dominate the market and now sits on 90 percent of all PCs around the world.
More than a decade ago, Gates issued a famous memo calling for Microsoft to shift its focus to the Internet, which resulted in a successful companywide effort to develop the Internet Explorer browser and unseat market leader Netscape.
To be fair, the company has had mixed success at best with its attempt to sell the world on the value of tablet PCs, and its Xbox video game platform, while powerful, growing, and also a focus of company investment, is still second to that of Sony Corp.(6758.T).
A Bill Gates memo sent to top executives in October marked a strategic turning point for the world's largest software maker, which had built its business on selling boxes of software to customers to install on computer desktops.
Microsoft's earnings outlook this week fell well short of Wall Street expectations, and analysts said the company would use increased income from updated product lines, most prominently its update of the Windows operating system and Office business software suite, to build an online platform of software and services available any time over the Web.
"It is now plainly evident that Microsoft is finally serious on embarking in a major strategic shift to confront both the challenge and opportunity posed by news advertisement and transaction supported online services and hosted applications," Lehman Brothers analyst Israel Hernandez wrote.
Goldman Sachs analyst Rick Sherlund estimates Microsoft plans to spend an additional $2 billion in the coming fiscal year starting July 1 with much of that investment to go toward building an ad-supported online service business in the mold of Google Inc. and Yahoo Inc.
"We believe Microsoft has been working to implement a strategic vision to leverage some unique advantages and become a player along with Google and Yahoo in the market for online advertising," Sherlund wrote in a note to clients.
Microsoft sees paid search as the first test in a larger ongoing competition for Internet ads.
Online advertising continues to win over clients abandoning television, newspapers and other traditional media. Forrester Research projects the online advertising to grow to $26 billion in 2009 from $15 billion now.
At the core of Microsoft's software services vision is Windows Live, an advertising funded one-stop shop for Microsoft's web services from e-mail to instant messaging to blogs.
In order to support such a platform, Microsoft is expected to spend heavily for computer servers and data storage. Local media reported earlier this week that Microsoft bought a 75 acre property in central Washington state to build a "server farm" that will hold thousands of data-serving computers.
Merrill Lynch expects Microsoft online unit MSN to get a significant share of an estimated $2.4 billion in additional spending by the company. MSN expenses would increase by $891 million in the upcoming fiscal year, compared with $1.1 billion for Google and $708 million for Yahoo.
Google and Yahoo have become household names, but Microsoft is still larger by far, from a financial perspective.
Before the stock fall on Friday Microsoft had a market capitalization of $282 billion and revenue in its latest full fiscal year of $40 billion, while Google had a market cap of $125 billion and revenue of $6.1 billion. Yahoo had a market cap of $47 billion and revenue of $5.3 billion.
Merrill analyst Justin Post also said the innovation from Google, Yahoo and Microsoft would also expand the Web advertising market, which is still relatively young.